Investment

What would Milton say?

Nobel Laureate Milton Friedman once said, “Inflation is the one form of taxation that can be imposed without legislation”. He also said, perhaps more famously, “there is no such thing as a free lunch”.
What would Milton say?


Nobel Laureate Milton Friedman once said, “Inflation is the one form of taxation that can be imposed without legislation”. He also said, perhaps more famously, “there is no such thing as a free lunch”.

In the tax year 2019/20, the UK Government raised £134bn from the collection of Value Added Tax (VAT). This was the second largest tax contributor to the Treasury, representing over 16% of all tax receipts. It is equivalent to almost £5,000 per household in the UK.

While the fifteen largest components of the EU (known as the EU15) raise similar or larger amounts from sales taxes, it is only the third largest source of tax receipt for the Union after income tax and social security charges.

Nonetheless, the largest economies in Europe, including the UK, generate a significant proportion of their tax income from the consumption of goods and services.

In that context, consider the following:

According to the Office of National Statistics (ONS UK), the UK Government has spent £172bn on direct COVID measures. The Bank of England (BoE) has loaned or guaranteed £92bn. In total, the ONS estimates that the UK Government has spent or been involved in spending £372bn related to COVID. This is equivalent to 20% of the UK’s Gross National Income recorded since Q2 2020.

Accounting techniques vary but estimates suggest that Germany has spent or guaranteed €827bn on COVID related measures. France was reported to have spent €470bn on similar measures up to late 2020 and is likely to have breached €600bn by the end of 2021. Italy is expected to have spent between €300bn and €500bn in the same timeframe. In almost all cases, EU member states have spent c. 15% of their GDP on COVID related measures, the largest peacetime expenditure since records began.

This spending will have to be recouped. It will also have to be raised in the spirit of “we were all in that together, so we all need to pay for it together”. Tax rate increases on income are unlikely to be viewed in that spirit, particularly given the widely held view that this penalises those who cannot afford an accountant.

However, in that Governments around the world have stopped returning calls from monetarist economists, there is every chance that the relevant monetary authorities may unleash inflation in order to “reflate” their specific economies. There is evidence that this is already occurring. The Governor of the BoE is on record commenting on a “wagey-pricey spiral” which the institution viewed as temporary. In the EU, core inflation was confirmed at 1.9% in June 2021. However, this covered a broad range of individual national rates. Germany, for example, has experienced recent rates of 3.8% while France and Italy have both recorded rates below 2.0%.

Inflating prices raises taxes without the accompanying furore over bands and equality. If you spend, you pay tax. With sales tax rates across the EU and the UK ranging from 19% (Germany) to 27% (Hungary), inflation of over 2.0% may provide a considerable hike in tax receipts at a time when, politically, there is limited scope to do otherwise.

Rising inflation is no friend to the equity market. Only recently, Reckitt Benkiser announced in its interim report that “cost inflation accelerated in the second quarter, and it will take time to offset this headwind with productivity and pricing actions”. Sensing a short-term cost impact, the London equity market marked Reckitt’s share price down by almost 9.0% in one day, a level from which it has not recovered as we write.

Reckitt, which counts Lysol and Dettol in its portfolio, is unlikely to be unique in this regard. The

vagaries of our response to COVID, all set in an environment where health trumps economics, has set the scene for a recovery which may see inflation across Europe to levels last seen in the 1980s. Temporary or not, this rise in the average price level is likely to provide a fillip for beleaguered national balance sheets which fillip monetary authorities may ignore for some time.

An inflationary environment asks different questions for management than the more recent price stability. Cost and supply chain management are likely to take precedence as companies, regardless of industry, seek to maintain or enhance margins. Branding, to establish pricing power, is also likely to move up the agenda. Overall, management may be tempted to “go with the flow” and accept cost increases on the grounds that output pricing can rise also.

In the private company sphere, the pivot to an inflationary environment is not without risk. Launching or developing products and services will require a greater focus on cost forecasting in order to establish accurate budgets. While the “next big thing” is likely designed for a specific market or demographic, costs are more broadly based. Staff costs, for example, will reflect the economics of the country in which staff live and not the ability of the product or service which they produce to command a premium price capable of growth.

History shows that managing inflation requires extreme measures. It also demonstrates that there is no such thing as “a little bit of inflation”. Once price increases enter an ecosystem, the multiplier effect is both considerable and long-term.

That said, national balance sheets need rebuilding. Raising tax on income may prove politically problematic unless entire tax codes are to be re-written. The temptation to let inflation back into our economies may be too great to resist for Governments despite the protestations of their monetary authorities.

To paraphrase Milton, lunch may not be free but the buffet offers the chance for multiple courses.

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